Has Apple's innovation engine stalled?

Jan. 14, 2013
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Apple CEO Tim Cook. / Eric Risberg AP

by Scott Martin, USA TODAY

by Scott Martin, USA TODAY

SAN FRANCISCO - Apple's profit-gushing iPhone came into question again Monday, briefly sending shares below $500 on concerns of a sales slowdown, as Wall Street's gizmo darling is in danger of becoming yesterday's glamour stock.

Shares of Apple skidded 3.6%, to $501.75, amid growing uncertainty about whether Apple can continue its pace of trendsetting innovation. The stock's latest fizzle was attributed to a report in The Wall Street Journal that says Apple decreased parts orders for its iPhone 5.

That came after Citi analyst Glen Yeung last month said that cuts to Apple's orders from its suppliers, while inconclusive, "bring into question the strength of iPhone 5 and refocus investors onto risks in the Apple story."

Under intense Wall Street scrutiny, Apple needs to dazzle consumers once again with the next big must-have thing in order to buoy its stock.

This month marks three years since Apple launched an industry-changing invention. Its iPad tablet was brought out by a beaming Steve Jobs, who introduced it as a "magical and revolutionary device." Now, that magic act is in question under CEO Tim Cook at a pivotal moment for the world's most valuable company.

"Investors are aware of how difficult it is for a technology company to continue to come up with products that are going to wow consumers." says Jay Ritter, a finance professor at the University of Florida.

Apple has failed so far to deliver an encore to its iPod, iPhone and iPad. This is critical for new growth, because the iPhone makes up the bulk of Apple profits - trailed by iPad - as competitors gain. U.S. markets have become saturated with iPhones.

Now, the battleground is shifting to Asia and emerging markets, where price-sensitive consumers are turning to cheaper Android-based devices.

"China is currently our second-largest market; I believe it will become our first," Cook told the Xinhua News Agency during a trip to Beijing last week.

Still, both television makers and content owners are on notice that next in line is a game-changing TV. Rumors are rampant Apple will do just that - to be followed by more years of fat sales, burgeoning market share and investment by Apple. But some signs point in another direction.

Studios and cable providers have made it clear they don't want to work with Apple and would prefer to create their own business models, notes Keith Bachman of BMO Capital Markets. "We remain skeptical on Apple's eventual foray into TVs," he wrote last week to clients. "We think this will be a niche market opportunity for Apple."

Needham & Company analyst Charles Wolf concurred. "I frankly would be surprised if they launched a TV," he says. "The economics of a TV are so difficult. It's low-margin; the upgrade cycle is really slow."

That's bad news for Apple. The company is under siege by rivals, and it's far from a sure bet that iPhones and iPads can continue to produce monster profit multiples.This all comes ill-timed for a slower-advancing Apple.

Under attack from Google's Android - which now commands 72% of the worldwide smartphone market, vs. 14% for Apple's iOS - Apple is stepping toward price competition rather than pulling off another rabbit trick.

Apple's innovation mojo -- in question since Steve Jobs died in October 2011 (Forbes dropped Apple to No. 5-ranked innovator for 2012 in the Cook era from No. 1 in 2011) - has Wall Street on high alert.

Apple's prospects will be no clearer than when it reports first-quarter earnings on Jan. 23. It's expected to report selling 45 million to 50 million iPhones for the all-important holiday quarter ending in December.

Apple commands 75% of worldwide smartphone profits, according to analysts, and its earnings are the envy of businesses around the world.

But Samsung on Monday said that it has sold more than 100 million of its Galaxy S line of smartphones since its 2010 debut.

Apple declined to comment.

Magic carpet turbulence

More than a year after Jobs' death, the question among Silicon Valley watchers is, how long can Apple's magic carpet ride last?

Apple faces growing competition from the likes of Google, Amazon.com and Samsung in the fast-paced tech market without its forceful visionary, says Vivek Wadhwa, vice president of academics and innovation at Singularity University. "Where is the latest and greatest from Apple?" he asks. "It's been a few years."

"Apple's biggest challenge is to define itself in the post-Steve-Jobs era," says Salesforce.com CEO Marc Benioff, who worked at Apple in the 1980s. "Where it is struggling is when it pretends to be Steve Jobs instead of actualizing its new identity. They need to find out who they are now."

Apple's advances are increasingly being met by products from Amazon's Kindles and Samsung's Galaxy devices - running Google's Android - as well as facing a rising threat from Nokia and other device makers running Microsoft's recently launched Windows 8.

In a me-too move, Apple came to the retail party with a smaller iPad after Google and Amazon launched smaller formats first - in the tablet category Apple created.

"I would hope they are working on something now. They need to keep this meteoric growth," says Jared Ficklin, a technologist at Frog Design, a design consulting firm that worked on early Apple computers.

Stock plunge woes

Apple needs a new game-changing product to nudge the stock. Shares of Apple have drooped about 29% since they hit an all-time high of $705.07 last year. Investors are concerned Apple can't keep growing at the same rate without consuming another industry. The big problem is, Apple has run up against the law of numbers: To grow on a significant percentage basis -- Wall Street's quarterly fix - requires massive growth.

"They fight the law of large numbers - the company will need to go to new markets" to keep growth up, says Edward Jones analyst Bill Kreher. "There's a lot of concern about innovation and what Jobs brought to the table."

Without a new invention, Apple needs to sell an ever-increasing number of iPhones and iPads.

"They've had such a fabulous run. It's just hard to sustain such high growth once you get that big," says Richard Sloan, a professor at the University of California at Berkeley. "Apple was sort of the king of the glamour stocks since about 2009 with increased visibility on increased sales in iPhone and iPad."

The run, at this rate, had to end. "Everyone thinks this is going to be a flat quarter" compared with a year ago, Sloan says.

'Value' company momentum

Apple has missed quarterly earnings estimates in three of the past five calendar quarters, including the past two, says FactSet.

Meanwhile, Apple's reputation as being a fast-growth company appears to be waning. Analysts expect the company to earn $13.46 a share in the December 2012 quarter, down 3% from the $13.87 a share it earned at the same time last year, says S&P Captial IQ.

Apple is now transitioning from a "growth" stock to a "value" one, financial experts say. The sell-off that carved billions off market capitalization was due, in part, to this concern, experts say. Institutional investors that have established growth-oriented funds could be liquidating their positions.

"Hedge funds could be pulling out," Sloan says. "I would suspect that it's the growth-oriented investors."

Value funds - think investors in Microsoft, General Electric and Coca-Cola - would be next in line to pick up the stock because Apple has a $121 billion cash hoard, pays a dividend that may increase, and remains a relatively safe haven for lower-risk investors.

"The market is certainly valuing Apple more like Google and Microsoft," says Ritter. "People are concerned: Is the smartphone market saturated?"

Price battle?

Apple could become a ho-hum value stock if the company transitions from innovator to commodity hardware maker. It's now entrenched in markets that are uber-competitive on features and prices.

The only advantages are Apple's focus on better hardware designs, home-brewed intuitive software and vibrant marketplaces for media and apps. Those still command a premium, but rivals are mimicking all areas of its business to grab a massive chunk of the market.

As a result, Apple appears ready to head down the path of price competition. The launch of its iPad Mini last year was evidence of its need to offer a tablet to compete with Amazon's smaller Kindle tablets and Google's Nexus 7, which are selling briskly. The device is also expected to make less money as it eats into sales of higher-margin iPads.

Speculation has run high that Apple may also offer a lower-cost iPhone to compete in emerging markets and Asia, where cheaper Android-based devices dominate. The Cupertino, Calif.-based company could cut costs by replacing its sleek aluminum chassis with a plastic one and packing in lower-performing components.

"There's tremendous pressure on Apple in Asia and some of these emerging markets," says IBB Consulting analyst Jeff Wang. "There is a lot of pricing pressure that's being created by unlocked or unsubsidized," less-expensive phones offered locally.

"Cutting the prices of their Apple products - it's a slippery slope into chasing a race to the bottom," says Allen Adamson, managing director of branding firm Landor Associates. Apple should "start thinking of themselves as a luxury brand rather than a mass brand. The margins are much better."

Contributing: Matt Krantz in Los Angeles and Jon Swartz in San Mateo, Calif.